Quantitative easing - a tactic in the currency war that is set to continue

Analysis

Quantitative easing - a tactic in the currency war that is set to continue

Don’t expect a new Plaza Accord from the G20

by Darrell Delamaide

Thu 14 Oct 2010

We must be in the middle of a currency war, since everybody says we are. It was Brazilian finance minister Guido Mantega a fortnight ago who first applied the term to the evil that dare not speak its name, but it has apparently been with us for some time.

In any case, it gave everyone something to talk about at the IMF/World Bank meetings in Washington last weekend. Predictably, despite much hand-wringing, nothing was done.

The crux of the matter – the currency impasse between China and the US – is anything but new. The prospect of further quantitative easing by the Federal Reserve – virtually a sure thing now after publication this week of the minutes from the September meeting of the Federal Open Market Committee – has exacerbated the problem, as it leads to further weakening of the dollar.

This creates stress all around as other currencies rise and the Chinese have to work harder to keep their quasi-dollar peg intact.

So other central banks are jumping on the QE bandwagon. Masaaki Shirakawa, governor of the Bank of Japan, said during the Washington meetings that advanced economies needed to stick with an easy monetary policy to support economic recovery. This after the Japanese central bank last week announced a reduction in its benchmark interest rate to near zero and its intention to buy up to Y5tn ($60bn) worth of bonds.

On Monday, British Prime Minister David Cameron reminded everyone that he has ‘always’ been a monetary activist. Chancellor of the Exchequer George Osborne said last week the government has no objection if the Bank of England wants to increase its bond purchase programme beyond the current £200bn ($319bn).

Is this then the newest tactic in the currency wars? Or will it simply drown the conflict in a flood of new money?

The Fed, for one, clearly seems focused on the need to give a monetary stimulus to the US economy, though presumably the impact on the dollar’s foreign exchange rate has not escaped Fed officials’ notice. Likewise, Japan and the UK couch their QE plans in terms of the domestic economy.

This leaves countries like Brazil, Switzerland and Thailand with the problematic task of intervening to slow down appreciation of their currencies – or of taking administrative action to constrain currency inflows. Is that a war, or just collateral damage?

In any case, this is why we see increasing calls for some sort of currency agreement like the Plaza Accord of 1985, which some people see as a possibility for hammering out at the G20 summit in November.

But the world is nothing like it was in 1985 and it’s hard to imagine how a currency agreement would look nowadays. It’s not likely the Chinese will say, ‘Oh, well, if you insist, sure we’ll revalue the renminbi by 20%.’ Unlike allies Japan and Germany on occasions in the past, China sees no need to toe the US line.

In absence of that concession, what else can be done? Will we see simply a hollow pledge for all countries to seek a putative ‘rebalancing’ of capital flows? That simply begs the question of how to achieve it.

The Chinese, of course, don’t see their currency as undervalued and refuse to be told what to do by others. The ‘solution’ to the world’s large trade imbalances, to the extent there is one, is for China to gradually increase the wages of its workers and to boost domestic demand.

The US insistence that China revalue its currency is as wrongheaded and eventually as ineffectual as Washington’s push in the 1980s for Japan to revalue the yen. The US trade deficit does not result from an undervalued renminbi and revaluing it will not fix global imbalances. China let its currency appreciate just over 20% against the dollar from July 2005 to July 2008, and the US trade deficit with China increased 33%, from $202bn to $268bn.

Misguided reactions to a wrong analysis of the situation seem likely to cause harm, especially since the only thing a polarised US Congress seems able to agree on now is that some sort of penalty has to be imposed on China for refusing to bend to the US will. Economic commentators of the stature of Fred Bergsten and Paul Krugman are urging lawmakers to take decisive action.

Perhaps the G20 will surprise us and find some face-saving way for China to give ground – another mini-revaluation of the renminbi or a pledge to increase wages over time. But that may not be enough to dampen the rhetoric in Congress. Brazil’s finance minister Guido Mantega had better start further honing his rhetoric on the currency war – because the conflict looks set to continue.